Cisco Isn't In A Death Spiral

| About: Cisco Systems, (CSCO)


Cisco reported quarterly results and guidance that handily beat analyst estimates, sending shares up 7% after-hours.

Growth from new units like security are offsetting declines in Cisco's legacy businesses while strong growth in developed markets is negating weakness from emerging markets.

With $30 billion in net cash, Cisco can afford its aggressive capital returns and should trade close to $30.

It would be fair to say long-term Cisco (NASDAQ:CSCO) shareholders have had a difficult time. Shares are basically flat over the past decade and are 14% below their 52-week high while major indices have been hitting new all-time highs. Over the past few quarters, Cisco has been reporting revenue declines and margin compression as legacy businesses face commoditization thanks to competition from new cloud-based offerings. To offset this decline, Cisco has been investing in security and cloud-based solutions, but this effort has yet to translate to positive results. However on Wednesday afternoon, Cisco reported solid quarterly results and offered decent guidance. This quarter is further evidence that Cisco is not in a death spiral, but is in fact stabilizing with the potential for modest growth in 2015.

In the company's third fiscal quarter of 2014, Cisco earned $0.51 on revenue of $11.54 billion while analysts were looking for $0.48 on sales of $11.38 billion (all financial and operating data available here). This solid beat helped to push shares up 7% after-hours. Now, it should be noted that the revenue was still down 5.6% year over year. While revenue was better than anticipated, we are not yet seeing growth, though individual units are showing pockets of strength. Importantly, we will see more progress on the revenue front next quarter as the company expects revenue down 1-3% year over year while most analysts were looking for a 5-5.5% drop. Thanks to stronger revenue, EPS should be $0.51-$0.53, compared to the $0.51 consensus. Cisco is sequentially improving its revenue picture, and there is a decent chance the company posts modest revenue growth in 2015.

Importantly, Cisco isn't sacrificing gross margins by discounting to secure higher revenue. Gross margins were a really solid 62.7% in the quarter, which was up 140bp from last quarter. The only blemish from guidance was for a sequential GM contraction to 61-62%. However, it is worth noting that CSCO previously guided to 61-62% for this quarter and easily exceeded this range. This may be a case where Cisco is offering somewhat conservative guidance to provide some margin for error. The sequential improvement in gross margins was positive and shows Cisco is maintaining more pricing power than the bears had argued.

Now, there are definitely still some problems in Cisco's legacy businesses. Product revenue is driving the problems at Cisco and was down 8% year over year. On the other hand, services continue to provide some growth with sales up 2.6% compared to last year. On the positive side, product orders were flat year over year. Cisco is booking more revenue than it is billing, which is contributing to the sequential improvement predicted next quarter. Orders are a leading indicator for revenue, and strong orders confirm the stabilization at Cisco. Set-top boxes remain the weak link at Cisco with sales dropping 26%. Cisco is diversifying away from this business, which is wise as increasing competition cannibalizes profits. With slowing demand, set-top boxes are a commoditized business, and I don't foresee any growth coming from this unit.

Date center revenue jumped 29%, powered in part by market share gains. Thanks to Sourcefire, Cisco continues to perform especially well on the security front with revenue up 10%. Importantly, orders were up 20%, so I expect revenue growth to accelerate from this unit. Router revenue was down 10%, while switch sales fell 6%. However, orders were better, which should lead to some sequential improvement. Wireless revenue was up a disappointing 3%, but the timing of orders distorted results, as orders were up a more robust 12%. Its Meraki unit continues to headline this growth. Cisco's growth units and push into the "internet of things" is helping to create some growth and offset the decline in legacy units.

Geographically, Cisco, like many US tech firms, is performing better in developed markets than emerging ones. US orders were up 7% while Northern Europe was up 4%. The United Kingdom's economy has been performing better of late, helping to push orders up 7%. Government austerity continues to weigh on Cisco, though, with US commercial orders up over 10%. On the other hand, the slowdown in emerging markets coupled with concerns over NSA spying led to a 7% decline in emerging market orders. With China focusing on using domestic tech companies, the decline was worse in BRIC + Mexico, with orders dropping over 13%. While developing markets are performing well, I expect emerging markets to remain a headwind for the rest of calendar 2014.

Finally, Cisco is using its fortress balance sheet to return some capital to shareholders. Earlier this year, it raised its dividend to $0.19, which gives shares a 3.3% yield. This dividend costs the company about $1 billion per quarter. Cisco also bought back $2 billion in stocks, or about 90 million shares. This was down from the $4 billion last quarter when Cisco took advantage to the very low price to aggressively buy back stock. Thanks to the buyback, the diluted share count is down by 200 million, or nearly 4% year over year. Cisco has about $10 billion remaining on its buyback authorization, and I expect the company to exhaust this program over the next 12 months.

Cisco has the balance sheet to do this. The company carries $50.5 billion in gross cash. Much of this cash is trapped overseas, so Cisco has been borrowing in the US to fund the share repurchases. As a consequence, the company carries $20.9 billion in total debt for a net cash position of $29.6 billion. This cash hoard comes to about $5.70 per share. With a strong balance sheet and solid free cash flow ($2.8 billion in the quarter), Cisco will continue to aggressively return capital to shareholders, resulting in higher dividends and earnings per share.

This quarter showed that Cisco is stabilizing and is not in a death spiral. Revenue declines are sequentially improving, and orders suggest this trend will continue. Cisco's growth businesses are also showing some growth, offsetting declines in the legacy business. With its strong balance sheet, capital returns will continue. Cisco will earn about $2.02 in fiscal 2014 and at least $2.10-$2.15 in fiscal 2015. On an ex-cash basis, Cisco should trade 10-12x 2015 earnings, as results are improving but not perfect. That suggests fair value is $26.50-$30. Even after the 7% after-hour rally, Cisco is definitely a buy.

Disclosure: I am long CSCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.